Why The Crisis In Cyprus May End Up Hurting You Too

Cypriots protest an EU bailout deal outside the parliament in Nicosia on Monday. A proposed bailout deal would slap a levy on all Cypriot bank savings.

Patrick BazAFP/Getty Images

Originally published on March 20, 2013 12:28 pm

Ask Americans to point out Cyprus, and most would have to spin a globe several times before noticing the small island nation, east of Greece and south of Turkey.

But whether or not you have ever given a thought to the 1.1 million people living there under the warm Mediterranean sun, Cyprus might send a chill up your spine this week.

That's because a Cypriot banking crisis has the potential to disrupt global financial systems, which are still trying to recover from the crisis of 2008-2009. Many economists are worried about the possibility of a new financial "contagion" starting in the eurozone.

How The Dominoes Might Fall

Let's set up the dominoes and see how they might start falling on the other side of the world — and end up hitting your life.

The first domino is Cyprus, a small and ethnically divided country that has long had a secretive banking system. Cyprus entered the European Union in 2004 and started using the euro currency in 2008.

Once in the EU, Cyprus kept expanding its banking system, taking it far beyond what such a small country could support. Assets ballooned to many times the size of the country's entire economy.

The next domino involves Russia. Five years ago, very wealthy businessmen in that country were looking to store their massive piles of cash somewhere. So they turned to those secretive banks in Cyprus.

Unfortunately, the Cypriot banks were still investing depositors' money in Greek bonds. And then, most of those Greek bonds turned out to be very poor investments, falling to "junk" status and then getting written down last year. Cyprus' banks lost 4.5 billion euros on just their Greek holdings.

Now those banks are in so much trouble that EU officials, with help from the European Central Bank and the International Monetary Fund, are trying to cobble together a bailout to keep them from collapsing. But the Europeans want the Russian depositors, whom they suspect of benefiting from corrupt banking practices in Cyprus, to help cover the cost.

A Tax On Bank Deposits

So on Saturday, officials said they would seek to impose a tax of 6.75 percent on deposits below 100,000 euros, and of 9.9 percent on higher amounts. That would raise 5.8 billion euros to help cover the bailout.

It may sound reasonable to ask wealthy Russians to contribute to fixes for problems they helped create. But wait. What if you were an innocent saver? You put your money into an insured bank account — and now a chunk of your cash is going to disappear to cover someone else's mistakes.

That has depositors wondering: Hey, isn't that just a legalized stick-up? On Monday, depositors in Cyprus rushed to cash machines and kept pulling out money until the ATMs were empty.

And people who have money in banks in other EU countries are wondering: Could it happen here, too?

Shaking Trust In The System

This starts to knock the dominoes closer to you. Many banking experts say the whole global financial system is based on trust. Some rules you just never violate, and Rule No. 1 is: Don't confiscate insured deposits to bail out corrupt bankers.

A take-the-deposits policy for Cyprus "sets a dreadful precedent for the rest of Europe," wrote Desmond Lachman, an economist with the American Enterprise Institute. "No longer can depositors in Italy, Portugal, and Spain feel secure that their deposits are safe from confiscation in the event of the need for an IMF-EU bailout package."

Economists fear this could prompt people to pull out money from other EU banks.

"There is the very real danger that ... depositors will feel increasingly uncomfortable about leaving their money in banks in these countries," according to an assessment by IHS Global Insight, a forecasting firm. Creating conditions for a run on European banks "could be opening a nasty can of worms" that would undermine economic confidence and growth throughout that region.

Hurting The U.S. Recovery

So here's that final domino: If Europe's banking system were to take a hard hit, the whole global economy could be weakened, and that would slow the U.S. recovery. In the last quarter of 2012, the U.S economy was barely expanding; it hardly needs new knocks in 2013 as European customers pull back from purchasing U.S. goods and services.

At this point, it's not clear what will happen next because Cypriot banks have been closed until Thursday to prevent bank runs. The Cypriot parliament has delayed a vote on the deposit tax until Tuesday, but there is no good Plan B for the banks in desperate need of a bailout.

Global investors have settled into a wait-and-see stance. For now, the dominoes are still standing, but many people fear they are wiggling.